Posted by Larry Doyle on February 25, 2009 8:49 AM |
The equity markets across all sectors have gotten off to a very rocky start for 2009 (down 15% on average). In the midst of that, a lot of institutions and individuals have fled to the safety of short term government funds, money market funds that now benefit from a government backstop, and other cash alternatives. On average, these investments pay Wall Street and fund managers perhaps anywhere from .1% to .3% of the assets being managed. Those fees will not make the managers rich anytime soon. How do they respond? Welcome to the world of “principal protected notes.”
These structured notes are marketed to track an underlying index (say the S&P 500) while guaranteeing no loss of principal. Wow. Sounds like a great product. Where do I sign? Well, hold on just a second. I am not stating that structured notes do not have some degree of merit, but one needs to be very cautious in fully understanding how these notes work before purchasing. Questions a potential investor should ask:
1. What is the fee structure? Meaning what is the annual charge in order to get the comfort of that guarantee? Do not be surprised if it is anywhere from 1.5% to perhaps as high as 3% of your assets charged on an annual basis. Why so high? For the manager to hedge the volatility in the book of underlying assets, he has the head start provided by your fee.
2. What is the base rate earned by your money? Meaning what will the manager pay you for holding your assets. If the manager has sold out of stocks or other assets of the underlying index, and has your assets parked in a cash vehicle, what do you earn? Check that rate versus what you can earn in a separately held cash account.
3. What is the time to maturity of the note? Any manager will want to lock up your money for as long a period as possible in order to collect the fees earned. The longer the maturity, the less flexibility you have to manage your finances.
4. Where is the credit risk involved in the product? It is critically important to understand this exposure. Is the product an obligation of an insurance company, a bank, a money manager? You can rest assured there will be no reasonable secondary market for these structured notes so you will be locked into this credit exposure.
These notes are not “bought” they are “sold” and they will be very aggressively marketed by the financial industry in the days, weeks, and months ahead. I hope your financial planners are looking out for you. Trying to help you naviagte the economic landscape.
The WSJ provides some excellent insights on how ‘Safe’ Products May Pose Risks for Investors.